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New York | Last week The Institutional Risk Analyst participated the Ginnie Mae Summit in Washington. The event was packed and featured some important discussions about the state of the residential mortgage market. We received applause from the audience for suggesting that FHA resolution costs for defaulted loans should be the same as the GSEs. But hold that thought. And there were lighter moments. Federal Housing Finance Administration head Mark Calabria continued to backpedal skillfully regarding the prospects for taking Fannie Mae and Freddie Mac out of conservatorship. In a matter of weeks we’ve progressed from the status quo is “unacceptable” to a plea for power to create more GSEs to a concession at the GNMA event that Congress needs to get involved. Odds of seeing a roadmap for GSE reform from the Trump Administration in 2019 are fading fast. Hit the bid. One of the more important topics of discussion at the event was the high level of prepayments experienced by holders of GNMA mortgage backed securities (MBS), particularly from loans guaranteed by the Veterans Administration. Investors in MBS are getting killed by prepayments, but lenders are cheering because cheap refinance volumes are a welcome relief after years of declining profits. And this is a problem that affects GNMA and the GSEs Fannie Mae and Freddie Mac equally. After all, if you are the Bank of Japan and you’re paying 105 for a GNMA MBS, receiving prepayments at par when a mortgage loan is refinanced is painful. We recall years ago having similar discussions with Japanese banks and insurance companies. And we were always sympathetic. Mindful of the stress felt by its precious global investor base, the folks at GNMA and the Federal Housing Administration have sought to shift the blame for high prepayments to lenders and servicers. In January, GNMA imposed restrictions on loanDepot for allegedly “churning” loans to veterans. Previously, similar restrictions were imposed on Freedom Mortgage and GoldenWest. “Ginnie Mae cracked down on what it believes is unnecessary loan churning in its VA pools. Said actions are understood to be the result of those efforts,” Housing Wire reported. Like Freedom, loanDepot will see the removal of such restrictions “based on the Issuer having demonstrated to Ginnie Mae’s satisfaction that (a) its prepayment speeds are substantially in-line with those of equivalent multi-Issuer cohorts, and (b) such improved performance is sustainable,” GNMA said in a statement. The actions of GNMA against specific issuers is more politics than substance. Members of Congress like the idea of getting tough on “VA churning,” even though the problem may not actually exist to a significant degree. Black Knight, for example, reports that there are now 7 million households who could likely qualify for a refi and save at least 75bps on their mortgage coupon. This situation kind of reminds us of the Congressional hearings on CIA waterboarding of Al-Qaeda , which featured several terrorists who were never actually tortured. In Washington, fake news is only exceeded by imaginary policy. It’s high time that GNMA realized that persecuting issuers for supposed "churning" of VA loans is not going to solve the far broader problem of higher prepayment speeds. Just watch the earnings bloodbath in mortgage servicing rights (MSRs) this quarter by banks and non-banks alike. Does GNMA actually think that owners of MSRs among its issuer community want to push prepayment speeds higher? Really? But lenders do understand that when mortgage rates are cut by 1/3 in six months, somebody somewhere is going to make a new loan. When our friends in the third-party MSR valuation channel show constant prepayment rates (CPRs) surging over 20% of the remaining value of loan pools given a 50bp decline in rates, what more needs to be said? The 10-year Treasury note is down over a point in yield since December 2018. More important, the shape of the yield curve and the volatility surface have also shifted since December. New production pricing for conventional loan servicing assets is down by a third since October. First, our friends at GNMA have forgotten (or perhaps never knew) that you should listen sympathetically to investors who are experiencing prepayment risk and related convexity – but that’s all. Express concern, then put the phone down and go back to work. This is one of the first lessons you learn on the Street. Given that the problem of prepayments has to do with interest rates, which are controlled to some degree by the Federal Open Market Committee, there seems to be little real utility to GNMA in beating on its shrinking pool of issuers. Since Fed Chairman Jerome Powell did his first pirouette in December, as deft a political repositioning as you’ll ever see, the rate of prepayments across the mortgage industry has soared. Powell has continued the policy shift with some striking fouettés , but medium to long-term interest rates continue to fall. Good for lending, bad for MSRs. Second, GNMA and the GSEs need to recognize that loan servicers do not control prepayment rates. The fact that they know the address of the obligor is helpful, but the pitiful, sub-25% refinance retention rate in the mortgage industry suggests that servicing the loan does not necessarily lead to future business. Fact is that with rates falling precipitously, refinance loans are going to be made. Of note, modeled prepay speeds for 4 percent coupon conventional loans across the country are into the mid to high teens and may go higher. That means the MSR will basically amortize and disappear in five years or less. The third key factor we’d offer up to the folks at GNMA regarding prepayments is the economy. When interest rates gyrate as they have for the past six months, an American family are faced with the prospect of saving hundreds of dollars a month on a mortgage deserves that opportunity. Why shouldn’t a young military family benefit from a lower mortgage? The logic of GNMA looks dangerously like the predatory actions of the GSEs after 2008, when increased loan level pricing adjustments were used by Fannie Mae and Freddie Mac to deliberately prevent refinancing of loans held in GSE portfolios. Given the fact that home owners have the legal right to refinance without penalty , we think it is appropriate to ask why GNMA has chosen to punish lenders and issuers who ultimately have little control over the rate of prepayments. We hear that the folks at Fannie Mae and Freddie Mac have similar concerns. Well, get used to it. Capitalization level assumptions for new production MSRs peaked last Fall and are falling dramatically due to falling interest rates and high levels of prepayments. Ponder conventional 4s that traded at over 4x cash flow in 2017 now trading below 3x cash flow as average lives tumble. GNMA discount coupons are heading towards 2x multiples. Requiring an appraisal on all VA mortgage refinance transactions fixes the VA churn problem immediately, we are told by several issuers. But the FHA is unwilling to provoke a political battle with the Veterans Administration, which views VA loans as a benefit for men and women in uniform. So as with most things in Washington, we talk about problems that don’t really exist to justify inaction on measures that would actually fix the true problem. All we can say is that rates are headed lower, perhaps sub 2% for the 10-year note for an extended period. And frankly the mortgage industry, which also talks to investors in mortgage backed securities, is already exercising considerable restraint in regard to prepayments. “The mortgage industry could double prepayments,” one prominent mortgage executive told The IRA last week at the Ginnie Mae Summit. If GNMA really wants to make a difference for investors and the issuers who comprise this $2 trillion asset market, they should focus on how to streamline the loan resolution process and eliminate bottlenecks that can cost GNMA servicers thousands of dollars on a foreclosure. And specific to GNMA concerns about maintaining market liquidity of MSRs, when the resolution costs are level with the GSEs, then GNMA mortgage servicing assets should trade at a premium to GSE assets instead of a discount as today. Now that would be something to celebrate for investors and issuers alike. . #GinnieMae #MSR #FHA #VA

New York | This week we announce the release of The IRA Bank Book for Q2 2019 , a publication of The Institutional Risk Analyst . In this issue we ask some important questions, including: ** Why is Capital One Financial (COF) a better comp for Citigroup (C) than JPMorganChase (JPM)? ** Why are loss rates for real estate exposures of US banks moving back into positive territory? ** Will funding costs for banks continue to rise even as long-term Treasury yields fall dramatically? ** And just when is Fed Chair Jay Powell going to admit that the past eight years of "extraordinary" FOMC policy did nothing for inflation but did embed future credit risk in financials? Read and learn. Oh and we see no rate cut by the FOMC in 2019. One chart we did not use this quarter in The IRA Bank Book bears inspection, namely the rate of change in growth rates for various types of bank deposits. We note that “the high rates of deposit growth seen in the 2010-2016 period during the Fed’s “quantitative easing” operations have now been replaced by low or even negative growth rates.” Source: FDIC We write in The IRA Bank Book Q2 2019 : “As Q2 2019 comes to an end, short-term money markets remain tight due to the fact that the FOMC continues to shrink the Fed’s holdings of securities. Because the US government is running a fiscal deficit, for every dollar of Treasury securities on the Fed’s System Open Market Account that is redeemed, a dollar of bank deposits disappears when the Treasury refinances the bond in the private markets. The deceleration in deposit growth is a matter of concern because new lending is ultimately a function of the availability and cost of deposits. In particular, the decline in non-interest bearing deposits has negative implications for bank net interest income and overall profitability.” As we discussed on CNBC last week, the FOMC is still tightening policy. We believe that there is growing risk in the non-bank financial sector due to erratic moves in interest rates, the flat Treasury yield curve and the decline of carry in loans and financial assets. The culprit here is the shrinking balance sheet, which represents continued policy tightening by the FOMC. As rates have fallen towards zero, the behavior of loan and securities markets reflects a level of volatility and demand caused by the lack of cash flow or "carry" on financial assets. We do not expect a rate cut by the FOMC this year, contrary to conventional thinking on Wall Street, but we do anticipate an end to the shrinkage of the System portfolio by September and with it a resumption of reinvestment of all bond redemptions. We believe that it should be obvious to policy makers, regulators and investors that operating in a flat yield curve environment near the zero rate boundary is not the same as 20 or 30 years ago, when the cash flow off of financial assets was far more significant to asset returns and inflation expectations, one of the explicit policy goals of the FOMC. Banks have different default rate targets for customers. The Fed has skewed these risk measures via QE. As credit metrics return to normal, so will loss rates. The growing stress we see in non-bank finance today, however, is nothing compared to the pressures that will be unleashed in 12-18 months when visible default rates start to rise. The inflation of asset prices in stocks, bonds and loans has concealed a great many sins in the world of credit over the past decade. Eventually these hidden default events will surface and reflect their true economic value. And ground zero for the next crisis in mortgage finance will be, ironically enough, the the market for government guaranteed loans issued into the Ginnie Mae securities market.

New York | Last week in The Institutional Risk Analyst, we gave you a taste of today’s interview with author and consultant Jim Rickards to talk about his latest book, “ Aftermath: Seven Secrets of Wealth Preservation in the Coming Chaos. ” As usual, Jim has a commanding view of the ebb and flow of the global political economy. His first chapter in which he describes the fateful role of former Fed Chairman Ben Bernanke in choosing the current monetary policy mix sets the stage for an important discussion of the future risks facing investors. Jim is a good friend, fellow member of The Lotos Club of New York and among the most prolific authors writing about global finance and economics today. The IRA: Thank you for taking the time Jim. In the beginning of your book, you use the metaphor of The Odyssey to describe the choices facing the Federal Reserve Board going back to Alan Greenspan, who we knew as “Uncle Alan” in Washington years ago. You talk about how the Fed went from deflating bubbles before Greenspan, as with the “taking away the punch bowl” image, then to trying to maintain bubbles, and now overtly using monetary policy to stoke inflation and huge asset bubbles. Where does that leave us today? Rickards: In the book I talk about how Greenspan defeated deflation in 2005 before he left office, but, this was a Pyrrhic victory. Low rates gave rise to the housing bubble and subprime debt crisis. Since 2008, we’ve had more of the same but a more extreme version of Greenspan’s anti-deflation medicine. If Greenspan’s three-year experiment with sub 2% rates gave rise to the Global Financial Crisis, what was the world to make of the Bernanke-Yellen policy of 0% for seven years? Bernanke’s Federal Reserve also engaged in a completely unprecedented money printing binge called quantitative easing. The IRA: Well said. In the book, you talk a good bit about how the US economy has experienced increasing difficulty achieving the perceived levels of potential growth. This leads to the FOMC “doing more” to boost employment and now inflation under its 50-year old mandate. Yet the Fed also seems to be making some of the very same mistakes that were made in the 1920s and 1930s. Rickards: Going back to the 1929-1937 period, the old rule was to prick bubbles to relieve speculative pressures. But, this ended up causing recessions rather than preventing them. By the 1998 - 2001 period, the conventional wisdom was to let bubbles run their course and then clean up the mess afterwards. But the Fed has failed to distinguish between credit driven bubbles and mania driven bubbles. The former are dangerous because they are connected with the credit system, the latter less so because people loose money but the crisis is not systemic. The 2000 dot.com bubble was speculative, but not credit driven so it did not turn into a systemic crisis when it popped. Of course 2008 was credit driven and it did metastasize throughout the system right up to the top of the food chain with large banks and the housing GSEs failing. When you are kicking around the idea of should I or should I not pop the bubble, this is a key distinction and the threshold question for policy. You should pop or defuse credit driven bubbles, but perhaps let speculative bubbles (most recently Bitcoin) run their course. The problem is that Fed policymakers do not seem to grasp this fundamental distinction. This leads to credit bubbles being allowed to spin out of control into systemic crises. The IRA: You clearly lay the authorship of the 2008 crisis on Greenspan. But how do you distinguish between a market bubble and a credit bubble when the latter is made to seem less problematic because the central bank is actively creating asset bubbles? Loss given default for most bank owned real estate loans has been negative for three years or more. When banks are profiting from loan defaults, is this not a red flag? The Fed has explicitly embraced a policy of stoking asset prices in stocks and real estate to fight deflation, even if it means market instability as a result. Rickards: That is a profound question you raise about the impact of monetary policy on visible credit metrics. The answer very simply is that you can’t get out. It's one thing when loose monetary policy results in private credit extremes. The Fed can reign that in. But, what happens when public credit from the Fed is the source of the problem? The Bernanke choice of stoking asset price inflation via zero rates and QE is not something that can be reversed without a great deal of pain. Once you make that trade-off between promoting inflation and future market instability, you have no way out. You’re much better off taking the pain and accepting a lower level of economic growth in the short-run rather than deferring the pain but creating far larger asset bubbles down the road. There is no way out of the Bernanke policy choice without bigger bubbles and much larger market crash that results. This is why I believe that we face a financial market crash as bad or worse than 1929 or 2008. The IRA: American politics over the past half century has not been very accepting of limitations on growth or spending or debt. Are you saying that we need to prepare the survival strategy for the coming Mad Max era of financial ruin? We are struck by the parallels between the 1920s and today that you highlight in the book, the lack of clarity from supposed political leaders on economic choices. Rickards: One of the points of “Aftermath” is that we have already made that choice of greater and greater swings in boom and bust. Now we’re stuck with it. How you navigate these treacherous waters and protect wealth is now a crucial question for investors and professional advisors. The key point of the book is that we made the choice, we ran out the tape for 10 years, but now we cannot get out of this cycle. The proverbial punch bowl is now glued to the table and the Fed is forced to keep refilling it. The IRA: Or as our friend Jim Grant has written, Fed Chairman Jay Powell is truly a prisoner of history and the choices made by his predecessors. Rickards: Precisely. In the beginning of the Reagan presidency, we had the worst recession since the 1930s. But by 1983 we were growing at over 5% annually. Ronald Reagan said get the recession over early and then won the biggest reelection landslide in the 20th Century. Looking at today, we’ve been in a depression since 2008, at least as defined by John Maynard Keynes. But going back to the question of actual vs. potential growth, it seems to me that we face three big headwinds. First is the issue of demographics. We have stagnant to down populations in major nations around the world. Second, debt is a major drag on economic growth today, including things like student debt. Young people with big debt loads have lower FICO scores, making it difficult to get a job or buy a house. This delays household formation, which is a major driver of consumption. And thirdly we have the negative interest rates, which is an explicit transfer of wealth from creditors to debtors, especially governments and other public sector debtors. The IRA: So would you agree that negative interest rates have actually been a drag on growth, essentially a regressive tax on all savers and investors? Rickards: Yes, absolutely. And this is why I spent so much time talking about Reinhart and Rogoff and the 90% rule. When a country’s debt rises above 90% of GDP, growth suffers and additional policy actions meant to boost growth loose their effectiveness. Once you get past 90%, all of the rules regarding economic policy change. Why is the 10-year note at 2.1% this morning? And this is only going to get worse by the way. Reagan got a huge bump up in growth because he increased spending and deficits, but the same policy actions 35 years later gets barely any uptick in growth. The White House today is ecstatic about 3.1% growth in the first quarter, but go back and look at the Obama years and the wide swings in GDP that we experienced. Low rates and stimulus had some effect in terms of boosting growth but it was not sustainable. There was no real difference between Trump and Obama in terms of growth. The tax cuts gave us a bump, but only just a bump. It was not a paradigm shift, just a bump that is not sustainable. We are back to that 2.2% trend growth of the past ten years that is lower than the post-war average and thus qualifies the past decade as a depression using Keynes’s measure. The IRA: Growth also seems to be below the rate where you can keep the politics under control, thus we have all sorts of manic responses from bitcoin to MMT and other new age “solutions” to the problem of low growth. How do you see the future given your views of the likelihood of greater market volatility? Rickards: When all of the solutions from Washington and all of the big ideas about economic growth fail, then we may need to fall back on a community based, semi-agrarian model that resembles austerity in today’s terms. Such a model is far more stable than the radical boom and bust model of Greenspan and Bernanke. Larry Kudlow is right to think that we can do better in terms of growth, but the headwinds we spoke about are daunting and the policies are not well-designed to achieve that kind of growth. The IRA: So what is the path back to some type of sanity regarding economic growth? Rickards: We need to move beyond ideology and towards a more pragmatic discussion about how we measure and describe growth. Let’s do what works. The great philosopher William James invented pragmatism and taught us not to get hung up on one school of ideas or another. I’ve always been an admirer of Keynes and a fierce critic of what we call “Keynesianism” today. As soon as Keynes was dead, the economist Robert Samuelson hijacked his legacy and created something completely new called Keynesianism. But what I admire about Keynes is that he was pragmatic, a man who understood the art of policy but also knew the workings of markets intimately. In 1914 at the start of WWI, Keynes was a gold bug because he saw it as a way to preserve Britain’s credit standing and let them win the war. By 1925, Keynes was opposed to gold because he saw it as a constraint on growth. But by the end of WWII, he supported a modified gold standard to underpin the global monetary system. He believed in what worked. That is the kind of thinking we need today. The IRA: Thanks Jim #JamesRickards #FOMC #BenBernanke #JayPowell #janetyellen #AlanGreenspan

New York | A year ago in The Institutional Risk Analyst , we predicted that net interest income for the US banking industry would flatten out and decline around Q1 2019. Sure enough, that is precisely what has happened. We wrote in The IRA Bank Book for Q1 2019 : "The cost of funds for US banks continues to grow at four times the rate of interest income, suggesting that the net-interest margin earned by banks may start to decline in 2019. Rising funding costs are being felt the most by smaller banks, driving the rate of change in interest expense over 70% year-over year 2017-2018. Quarterly funding costs for all US banks should be close to $60 billion by the end of 2019 vs $37 billion in Q4 2018, a mere 62% rate of change as shown in the chart below." Source: FDIC As short-term deposit costs normalize, the margin on loans and other assets that banks earn over funding is being squeezed. We notice that the 10-year Treasury note closed at a yield of 2.13% on Friday, more than a point below the November 2018 peak yield of 3.25%. So long as the Federal Open Market Committee persists in artificially propping up short-term interest rates, bank earnings will remain under pressure and many non-bank financial firms will be in jeopardy of outright failure. Markets are slowly coming to understand that the use of negative interest rates as a policy tool has more downside than benefit, especially when it comes to asset returns. We’ll be publishing a conversation with our friend Jim Rickards about his timely new book, “ Aftermath: Seven Secrets of Wealth Preservation in the Coming Chaos. ” In his latest work, Rickards notes: “It is understandable that the Fed wishes to resume what it regards as normal monetary policy after the better part of a decade of abnormal ease. The difficulty is that the Fed has painted itself into a corner from which there is no easy exit… Internally the Fed has congratulated itself on their fine-tuning and market finesse. They shouldn’t have. All the Fed proved in recent years was that they really couldn’t exit extraordinary policy intervention without disruption. The Fed has been storing up trouble for another day. That day is here.” It is important to note that Rickards joins a long list of economists and market observers who criticize the Fed’s reckless use of radical monetary policies to control markets. In an interview with The Financial Times , Dr. Judy Shelton calls on the Fed to “think about whether they are doing more harm than good”. If appointed to the Federal Reserve Board, the FT reports, she would be “asking tough questions” about its most basic mission. Maybe Dr. Shelton could also ask when Congress gave the Fed authority to nationalize the short-term money markets. “How can a dozen, slightly less than a dozen, people meeting eight times a year, decide what the cost of capital should be versus some kind of organically, market supply determined rate? The Fed is not omniscient. They don’t know what the right rate should be. How could anyone?” Ms Shelton argues. With the Fed holding up short-term interest rates and long-term yields falling under pressure from continued asset purchases by global central banks, the outlook for banks and other leveraged investors is decidedly negative. We’ll be discussing the growing threat to US banks and other interest rate dependent investors posed by the Fed’s unsafe and unsound monetary policies in the next edition of The IRA Bank Book for Q2 2019 . #Shelton #JamesRickards #NIM #FDIC

New York | In May of last year, we suggested that it may be time for Elon Musk to declare victory and sell Tesla Motors (TSLA) to one of the top global auto manufacturers (“ Should Elon Musk Sell Tesla? ”). BTW, notice the nifty new search feature on the top of The IRA pages. A year later, we watch as the likes of Audi AG and Daimler AG hammer away with advertising in new and old media displaying well-executed electric car offerings. Owing to a shortage of operating cash, TSLA has no response in terms of advertising message and no retail sales network either. Under the leadership of Elon Musk, TSLA operate s in extremis for all to see. As we wrote in “ Ford Men: From Inspiration to Enterprise, ” the global auto industry is a scary proposition for even the largest and most efficient operators. TSLA has neither scale nor sufficient funding to make let alone even market its products adequately. Adequate funding, to recall the wisdom of our friend Bill Janeway, provides the opportunity to properly plan and execute a business strategy. Notice the negative market beta for TSLA in the table above c/o CapIQ. To us, Elon Musk is a really smart man who needs an exit strategy. We like to say that hope takes a stock price up, but credit concerns bring stocks down. Right now credit concerns are predominating with TSLA as it becomes clear that the company cannot spend its way to profitability. Like Uber Technologies (UBER) and so many new age ventures hatched during the irrational era of negative interest rates, TSLA’s continued existence is predicated on access to new investor cash needed to finance operating losses. There does not seem to be any possibility that TSLA can grow to sufficient size and profitability to contend with the global incumbents led by giants such as Toyota Motor and Volkswagen AG. The TSLA common is now down about 30% over the past year, a reflection of the bad boy behavior of Musk and the now explicit need for new cash -- this after months of denying that any such need existed. Indeed, TSLA's price is about where it was five years ago . When Henry Ford started to display truly idiosyncratic behavior in the 1920s and 1930s, Ford Motor was private and protected by a gang of thugs led by the infamous pugilist Harry Bennett. The company was run like a plantation, bills were paid in cash, and Ford Motor Co had no net debt. Economists and writers could make fun of Henry Ford’s increasingly bizarre public conduct and monolithic product offering, but the company was not subject to a daily auction as is the case with TSLA’s stock and debt. Despite efforts by TSLA’s board and lawyers to control Musk’s obfuscation, he continues to paint a hopeful image of the future that seems difficult to square with reality described in his public disclosure. In the April 2019 TSLA conference call, Musk stated: “We are the only Company in the world producing our own vehicles and batteries, as well as our own in-house chip for full self-driving. We're in a position unlike anyone else in the industry. And in 2020, we expect to have 1 million robotaxis on the road with the hardware necessary for full self-driving. We believe we'll have the most profitable autonomous taxi on the market and perhaps the -- yeah…. In Q1, Model 3 was yet again the best-selling premium car in the US, outselling the runner-up by almost 60%.” Due to the reluctance of mainstream auto insurers to cover the TSLA cars equipped with the wondrous self-driving feature, Musk announced during the April conference call that the company would launch its own insurer. Adam Jonas of Morgan Stanley asked Musk why he did not take TSLA private given the “alternative capital and large amounts of strategic capital that is incrementally deployed in domains where Tesla has real leadership.” Good question. Musk’s reply: “I would prefer we were private, but unfortunately, I think that ship has sailed, so... Well, I mean, being public, does feels like the sort of price of the stock is being set in kind of a manic-depressive way. And I think Warren Buffett's analogy is just like perhaps being a publicly traded company is like having someone stand at the edge of your home and just randomly yell different prices for your house every day. It's still the same house.” Well, maybe. The house Musk describes in his inflated public statements bears little resemblance to the TSLA that has debt trading at a 20% discount to par. Sadly the ship may have indeed sailed for Musk in terms of obtaining new funds or even selling the company to a larger premium marque like Daimler or Audi. When Musk himself conceded during the April conference call that “I think there is merit to the idea of raising capital at this point,” he stated the obvious. A couple of days later on May 2, Musk told investors that he was planning to raise $2 billion in capital through new common equity and convertible notes. The move came after literally months of rejecting the idea of new share issuance, including during the April 2019 conference call with investors. “I don’t think raising capital should be a substitute for making the company operate more effectively,” Musk told shareholders on the company’s quarterly conference call, reports CNBC . “I do think there is some merit to raising capital, but this is sort of probably about the right timing.” Sort of probably? It is remarkable to us that the Securities and Exchange Commission gets visibly upset about Musk’s use of Twitter for his public dissembling, for example, yet ignores the seemingly clear manipulation of investors via selective and conflicting statements regarding a future offering of securities. But those poor helpless investors do seem to have figured out the basics since the announcement of the offering several weeks ago and have pushed down the price of TSLA sharply to close at $190 on Friday. Notice that Ford Motor just announced the layoff of 10% of all salaried workers as part of the latest restructuring at the Blue Oval. Renault and Fiat Chrysler are discussing a merger, this in the wake of the palace coup launched against Carlos Ghosn by his former colleagues at Nissan. This is bad news for Nissan, of course, who must now merge with another Japanese automaker since they apparently cannot abide the idea of union with a foreign company. None of these discussions, mind you, are driven by the potential for growth in the global auto industry. Instead the imperative is to cut costs in a stagnant commodity industry that suffers from chronic overcapacity and low or no profits. A number of former supporters of TSLA have abandoned Musk since the April conference call. “Morgan Stanley threw the biggest blow, declaring that in a worst-case scenario, Tesla’s shares could sink to a shocking $10,” Bloomberg reports. “A Wedbush analyst said the carmaker is facing a “code red situation” and cast doubt on whether Tesla can sell enough of its electric cars to make a profit. And Citigroup and Robert W. Baird & Co. analysts, among others, slashed their target prices, citing concerns about cash flow and consumer demand.” We still think that Elon Musk can salvage his reputation and value for his shareholders by selling TSLA to a global manufacturing company that makes premium cars. Audi, Daimler, Honda and Toyota are all obvious suitors. And TSLA is already cooperating with Fiat Chrysler Automobiles to help reduce the Italian-US firm’s liability for emissions in the EU. Just imagine Fiat-Chrysler, Renault and Tesla under a single roof. As part of the equity offering, TSLA will no doubt receive inquiries about an acquisition from several global automakers in Europe and Japan. As we noted last year, Musk has validated the idea of electric vehicles and has also created a very valuable brand. But can this accomplished business man and technologist admit that his brilliance is wasted on making mere automobiles? We’re thinking more of the Jetsons. Flying car to LGA please Mr. Musk. A century ago, Ford, GM and other US makers could not manufacture cars fast enough to meet demand. Today the name of the game in the shrinking auto industry is alliances and consolidation. Given that large Sell Side firms like Morgan Stanley have decided to throw TSLA under the bus, maybe it’s time to think about a sale? Even a valuation near Friday’s close for TSLA would be a gift compared with the worst case scenarios making the rounds on the Street. As and when the question is asked about acquiring TSLA, will Elon Musk be smart enough to take the call? For the sake of TSLA holders, we certainly hope that the answer is yes.

New York | This week The Institutional Risk Analyst is participating at The Mortgage Bankers Association Secondary Conference, one of the most important events of the year for the housing finance industry. One topic we heard a lot about from various attendees is that the volatility seen in Q1 2019 has thankfully subsided this quarter, but the continued deterioration of the effective spread on loans and securities, and rising prepayments, are big concerns. On Sunday afternoon we heard a panel at the MBA Secondary on recent attempts to attract greater levels of private capital to the market. Eric Kaplan of Milken Institute led a discussion with Liam Sargent of J.P. Morgan (JPM), James Bennison of Arch Mortgage Insurance Company and Matthew Tomiak of Redwood Trust (RWT). Bennison noted that there is considerable pent up demand for private label mortgage exposures, but issuers must bring the right types of products to market – as in the case of the GSE risk sharing transactions. When Matt Tomiak talked about the nuances of building the RWT non-agency mortgage business since 2010, we could not help but notice again the reference to a dearth of available assets – at least at yields that made sense to these veteran loan issuers. “Our biggest competition in the jumbo mortgage space is banks at the end of the day and also insurance companies,” he observed. “Water always looks for its lowest point. Mortgage loans are always going to find their lowest cost of funding.” “My feelings are almost hurt when people say when will private capital come back to mortgages,” Tomiak added. “We’re back, we’re here and have been for a while.” His comments made us recall that credit terms for mortgage issuers are more liberal than at any time since the financial crisis, but even this considerable concession has not been enough to offset the relentless erosion of profitability thanks to the Fed’s QE. To that point, Peter Fisher wrote last year in a chapter of a timely new book edited by John Taylor, “Should the Fed ‘Stay Big’ or ‘Slim Down’,”: “My view is that QE1 (2008 to 2010) had a positive impact in liquefying the banking system during and immediately after the financial crisis and that it prevented more, and more rapid, deleveraging of the US financial system. But I am deeply skeptical about the efficacy of QE2 and QE3 (2010 to 2016) in stimulating aggregate demand.” Indeed, not only did QE and Operation Twist not help the economy, but these speculative policies by the FOMC actually did serious harm to the world of mortgage finance, the second largest market in the world after US Treasury debt. That damage is starting to emerge as one of the chief risks to the financial markets in 2019. Ralph Delguidice at Pavillion Capital wrote last week in a note entitled “Curve inversion dead ahead” that further compression of profits for leveraged players may be the next shoe to drop: “The Fed has hit the effective lower bound as the BASEL rules that de-risk the dealer banks, and the (still) contracting system balance sheet converge to constrain the supply of private short-term credit flowing into the all-important money markets. With the Fed on pause and stalling global growth, the strong USD and wide DM return differentials will pressure US term premia lower and invert the effective real-money curve. Financials—banks and especially non-banks with no deposit capacity—are ground zero, as valuations reflect the ongoing collapse of loan carry.” Even as loan spreads and comparable fixed income returns remain under downward pressure, visible default rates continue to fall. “Strong April mortgage performance pushed the national delinquency rate to a record low,” notes Black Knight. “At 3.47%, it’s now at its lowest point on record. Plus, the 5.51% M/M decline in delinquencies was the strongest single-month April improvement we’ve ever seen…. Meanwhile, low interest rates and the spring home buying season continue to push prepayment activity upward. In fact, April’s 17% increase in prepays brings the three-month aggregate increase to 67%.” So while the credit environment is benign for now, the dynamics of low profits for new loan originations and rising prepayment speeds on MBS are combining to create the perfect storm for holders of mortgage servicing assets (MSAs). The Street, after all, marks its mortgage securities and MSAs to model. Rising prepayment speeds means a commensurate decline in the modeled NPV of loans, mortgage securities and servicing assets. The table below from the Mortgage Bankers Association shows the components of gain on sale when mortgage bankers sell loans into the secondary market. Notice that the numbers are not nearly as bad as one might think looking at the aggregate profitability data. “What's interesting is that while margins were down last year, they weren't down as much as some people thought they were,” notes industry veteran Joe Garrett of Garrett, McAuley & Co. Also observe that the portion of the total gain attributable to MSAs has been rising since 2014 and jumped 10% in 2018 alone. This provides yet another data point to suggest that Fed Chairman Jay Powell is wrong when he says that asset values are not inflated. The crucial issue for the mortgage industry and especially for the specialty investment funds and REITs in this sector is whether the rise in prepayments is a temporary phenomenon associated with the rally of the 10 year Treasury and the resulting good Q1 production environment or will be confirmed by future quarters. If prepayments continue to rise, then the Street is likely to see a good bit more pain in Q2 when it comes to mark-to-model on MBS and MSAs. The good news is that the MBA refinance index has fallen significantly since the end of April, thus the mortgage bankers, REITs and other investors in RMBS may be spared drinking from the bitter cup of rising prepayments through 2019. As we’ve noted for over a year, the structural increase in funding costs described by Delguidice in the short-term money markets is also working on the US banking industry, where interest costs are galloping along at a 70% annual rate of increase. We’ll be updating our projections for 2019 when the FDIC releases the Q1 2019 aggregate data for the US banking industry. For a number of reasons, we think that for banks, REITs and other leveraged investors, the minimum floor of funding costs is rising much faster than asset returns. That is, a classical funding squeeze a la the 1980s. More Reading When will non-QM loans and HELOCs take off? National Mortgage News (May 20) Should the Fed ‘Stay Big’ or ‘Slim Down’? Peter Fisher, Hoover Institution #REIT #MBA #MSAs #Kaplan

New York | In this issue of The Institutional Risk Analyst , we speak to Michael Bright, President and CEO of the Structured Finance Industry Group (SFIG). Prior to joining SFIG, Michael was the EVP and Chief Operating Officer of the Government National Mortgage Association, or Ginnie Mae. As COO he managed all operations for Ginnie Mae’s $2.0 trillion portfolio of mortgage-backed securities. Before joining Ginnie Mae, Michael was a director at the Milken Institute’s Center for Financial Markets. In 2013 Michael was a principal staff author of S.1217, the "Corker-Warner" GSE reform bill that passed the Senate Banking Committee the following year. While in the office of U.S. Senator Bob Corker, he also advised on a range of Senate Banking Committee regulatory policy issues. The IRA: Michael, let’s start off by talking about the early part of January 2019 when you departed from Ginnie Mae to join SFIG. The markets had just been through a very tough month. A lot of securities issuance essentially went to zero. Mortgage securities had been in a slump since that September. Fortunately the markets have largely bounced back, particularly corporates and mortgages. How do you think about that period and since then as head of SFIG? Bright: I have not had a lot of folks asking about the drop off in issuance. There were a lot of factors that combined to make December a challenging month for many of our members, including the Fed reducing the size of its balance sheet and the general increase in interest rates at the end of last year. And when it comes to mortgages, there are a lot of households out there with three and four handle mortgages, so there is a limit on how much production volume that you will see even given a decline in rates. Our job at SFIG is to facilitate and coordinate the dialog about just these issues among all of the participants in structured finance. The IRA: How would you describe the mood of the structured finance community in 2019? What sort of risks or issues are top of mind for your members? Bright: I’d say the mood is cautious optimism. Default rates are low and the overall tenor of the markets is quite positive, but the thing that makes all of us take pause is the question of how long can the current cycle last? How long can interest rates stay where they are or even move lower? The narrative has changed a lot since last year, so the biggest anxiety for issuers and the professionals that advise them is really uncertainty as to the market trend and how much of a role will the Fed play in the future. We are conditioned to expect extremes in market movements, so the prolonged period of relative calm is hard for people to process one way or another because there is no clear trend in credit or interest rates. The IRA: The financial media is constantly trying to hype every market move into some sort of cataclysmic event, but we don’t actually see that in the credit markets. Credit is benign and volatility is low. Net default rates on bank 1-4s, multifamily and even construction exposures are negative, suggesting that credit has no cost. We saw this phenomenon with a few banks in the 2000s, but now its the whole sector. Bright: I think you have two issues at work here. The media is endlessly searching for the "canary in the coal mine" story, the big expose that will reveal some unknown risk. Yet at the same time, you have a financial industry that is now so well capitalized and so risk averse that at times it seems hard to imagine how we could repeat the experiences of 2008. So the media continues to pursue a narrative that says catastrophe is around the corner, but we don’t see that as an industry and we do push back against that doom and gloom narrative. The IRA: One topic that is getting a lot of attention from policymakers in Washington is leveraged loans. Congress is holding hearings on the topic and presidential aspirants such as Senator Elizabeth Warren (D-MA) have made it part of their campaign spiel. There is even some novel litigation now about whether the 1930s era securities fraud laws should apply to leveraged loans. Do you see a problem in this market in terms of risk? Bright: If you trace the history of the Fed’s quantitative easing or QE, the growth of leveraged loans tracks the Fed’s intentions to take risk free assets out of the system and force investors into riskier products. At first the worry over QE was that it would stoke inflation, but none of those concerns materialized. Around 2013 and 2014, the discussion moved to whether manipulating risk preferences would result in unintended consequences in terms of financial instability. And the Fed did not even disagree. They conceded that financial instability could be a consequence of QE. Both Chairman Ben Bernanke and Janet Yellen were asked that specific question in their congressional testimony. The response from the Fed was that financial instability is a risk but we’d rather deal with deflation now and then deal with any financial stability problems later. Loans have been made to riskier companies and this is precisely what the Fed said five years ago that they wanted to see. So there is no surprise here. The default rates on leveraged credit are still very low, and it may go higher in the future, but nobody wants to be the one who misses the next big risk. The IRA: Well Chairman Jay Powell says that asset prices are not inflated, but you could make the case that the Fed wanted to inflate asset prices to counter the deflationary tendency cause by the massive accumulation of debt in the system. Given the relatively tranquil credit environment that we’ve discussed, what is on top of your agenda at SFIG? Bright: Our agenda at SFIG is to foster a dialog between the structured finance industry and policy makers. We have a unique position in the US because we have a structured finance market that allows lenders to create secured assets, finance this production and eventually sell those assets to end investors. This is an incredibly valuable asset for the people of the United States and has a big role to play in fostering and sustaining economic growth. But with the benefits of structured finance also come responsibilities. People in our industry know that getting it wrong on risk has real world consequences that can endanger financial institutions, markets and the entire economic equation. Educating policy makers about the benefits and potential risk is our job at SFIG. The IRA: The arbitrage in the financial markets post 2008 has been to move into asset classes that were not center stage in the last crisis. Commercial real estate, leveraged loans, collateralized debt obligations, auto loans have all grown significantly over the past decade. Issuers of leveraged loans, for example, have taken the position that the securities fraud laws from the 1930s don’t apply to these assets and therefore all bets are off when it comes to protecting investors. Do you worry that this sort of regulatory arbitrage may conceal risks that are significant to the industry and policy makers both? Bright: As an organization, SFIG has both the issuers and the investors under the same tent, so we are very focused on enabling precisely the sort of discussion that helps our community understand these issues and any attendant risks. We don’t just advocate for issuers. There is an important ongoing conversation between investors and issuers on topics such as loan covenants and other protections. One of the great things about my job is that our chief goal is to bring all of our members together to discuss these issues on a continuing basis. Do we worry about these issues? Of course, that is our job. The IRA: Going back to your days at Ginnie Mae, one of the big questions on the table is what happens to Fannie Mae and Freddie Mac once they exit federal conservatorship. The new head of the Federal Housing Finance Administration, Mark Calabria, has said that the GSEs need more capital to exit conservatorship. There are people in Washington who seem to believe that the GSEs can operate as they do today without a federal credit wrapper. Do you worry about what happens to the mortgage market if the political sound bite about “protecting taxpayers” becomes an end of credit support for Fannie Mae and Freddie Mac? Bright: There are two outcomes for the GSEs that are unambiguously safe for the financial markets. The first is conservatorship. The markets understand conservatorship and accept that the Treasury is backing both GSEs. Ginnie Mae paper trades at a slight premium to the GSEs, but they are close enough. The market also understands a congressionally authorized credit wrapper as is the case with Ginnie Mae explicitly. Those are the two extremes that the markets understands. This is why foreign central banks are comfortable with Ginnie Mae because the governmental wrap is clear and unambiguous. The middle ground is quite unclear in terms of market acceptance. The idea that there is some amount of private capital that gets you to the same market acceptance as either conservatorship or an explicit guarantee from Treasury strikes me as wishful thinking. Any outcome that does not involve explicit credit support for the GSEs runs the risk that markets and particularly global investors will not accept it. The IRA: Thanks for your time Michael #MichaelBright #risk #leveragedloans #elizabethwarren #SFIG #MarkCalabria

New York | In this issue of The Institutional Risk Analyst, we feature a market comment from Robert Eisenbeis, Vice Chairman & Chief Monetary Economist at Cumberland Advisors . Dr. Eisenbeis asks: Why is the stock market showing more volatility than bonds? Why indeed. He concludes with a typically concise summation: "The lesson here for stock market investors is that hoping for a rate hike as a substitute for considered analysis is not a good strategy." On Wednesday, the FOMC left its policy stance unchanged. This decision was consistent with the message sent after the previous meeting and was not contradicted by speeches given by FOMC participants in the intermeeting period. This action was also consistent with the consensus view of economists who follow the Fed. Indeed, of the 39 economists responding to the April 23–25 Bloomberg poll, only two had forecast a rate cut in 2019 while the rest had the funds rate target steady through 2020.[1] Despite this data, the stock market declined after the FOMC statement was released, indicating that a rate reduction had been expected but not delivered. The market continued to decline over the next two days. In contrast, on Wednesday, May 1, the ten-year Treasury rate rose at about 10 AM and then jumped even higher just before the release of the FOMC statement at 2 PM, then dipped slightly before the meeting, as the Bloomberg chart below indicates. It then recovered to pre-10 o’clock announcement levels after Chairman Powell’s press conference. How can we explain these reactions to the information flowing from the FOMC meeting? Why was the stock market’s reaction more prolonged than the Treasury market’s was? Source: Bloomberg In the case of the stock market, rhetoric from some politicians and even a now-former Fed nominee argued that the FOMC had made a mistake in raising rates in December 2018 and that time was ripe for a rate cut. Economic growth appeared to be slowing through 2018, with Q3 growth below Q2 growth while Q4, at 2.2%, was below Q3’s 3.2%. Participants were expecting a modest number for Q1 2019, especially since first-quarter growth had been slow for the past five years and we had a full government shutdown for a full one third of the quarter. Everyone expected the shutdown to subtract from Q1 growth. Finally, in addition to expected slow growth, part of the rationale on the part of those expecting a possible rate reduction lay in the fact that inflation had been running persistently below the FOMC’s 2% target, and thus at some point a rate cut would be necessary to further stimulate inflation via extraordinary monetary accommodation until the target was achieved. Of course, we learned that this scenario did not match the view of the FOMC. Chairman Powell, in his press conference, countered the idea that inflation was “persistently below target” when he stated that the decline in inflation in 2019 was not only expected but also was viewed as being due to “some transitory factors.”[2] If markets had assumed that inflation below target was persistent and hence would soon require a rate increase – especially if the FOMC was as committed to its inflation objective as it was to the other leg of its dual mandate – then Chairman Powell, when questioned by an astute reporter, effectively shut down the possibility of a near-term rate cut to achieve the FOMC’s inflation objective. Nancy Marshall-Genzer asked, “You were saying if inflation does stay low and these low inflation rates are not transient, you said a couple of times you’ll take that into account with monetary policy. How, specifically, will you take that into account?” Chairman Powell’s response was extremely vague. He stated, “It’s hard to say, because there’s so many other variables. Ultimately, there are many variables to be taken into account at any given time, but that’s part of our mandate. Stable prices is half of our mandate and we’ve defined that as 2 percent, so we’d be concerned and we’d take it into account.” The reporter pushed further asking whether an interest-rate cut would be possible, and Powell responded that he could not be more specific. That interchange, combined with Powell’s use of the word transient, was interpreted by markets as indicating – as the economists’ Bloomberg predictions had implied – that policy was on hold for the foreseeable future. There would be no rate cuts to satisfy stock market investors’ desire for more stimulus; and as far as the Treasury market was concerned, the meeting was a blip, as it returned to its pre-meeting position. If there was any doubt, the 3.2% Q1 preliminary growth estimate, coupled with Friday’s CES report of a 3.6% unemployment rate and over 263,000 jobs created in April, clinched the fact that no rate cuts are on the horizon. Interestingly, if the FOMC meeting had been a week later, there would have been no shock to the stock market. The lesson here for stock market investors is that hoping for a rate hike as a substitute for considered analysis is not a good strategy. [1] https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20190501.pdf [2] https://www.bloomberg.com/news/articles/2019-04-26/economists-see-fed-on-hold-through-2020-with-no-rate-cut-survey #Eisenbeis #Cumberland #FOMC #JayPowell

New York | In this issue of The Institutional Risk Analyst , we talk to our friend Hans-Joachim (Achim) Dübel of FINPOLCONSULT in Berlin to provide some context for the latest troubles affecting Deutsche Bank AG (DB) and the German banking system more broadly. Dübel is one of those rare independent analysts of the banking sector in the EU and has worked on a number of internal and external debt restructurings. But first we need to comment on the end of Q1 2019 earnings and, with it, the top of the rally in the bond market. Since October the Street has been rotating out of risk assets such as collateralized loan obligations (CLOs) and into safer corporate paper, causing a short term rally in both the bonds and related spreads. The policy pivot by the Federal Open Market Committee, however, has interrupted a large asset allocation shift, leaving managers around the world wondering: What the do I do now? Managers of mortgage assets are asking the same question, especially as prepayments rise and loan retention, when homeowners refinance their mortgage, is falling. “In Q1 2019, fewer than one in five homeowners remained with their prior mortgage servicer after refinancing their first lien,” said Black Knight’s (BKI) Data & Analytics Division President Ben Graboske. He adds: “That is the lowest retention rate we’ve seen since Black Knight began tracking the metric in 2005. Anyone in this industry can tell you that customer retention is key – not only to success, but to survival. The challenge is that everyone is competing for a piece of a shrinking refinance market, the size of which is incredibly rate-sensitive, and therefore volatile in its make-up.” The Q1 rally in the bond market pretty much stopped at the end of April, concluding the bull case both for mortgage finance and bonds. A number of more astute players have rightly taken the Q1 bond market rally as a “transient” phenomenon, to borrow the words of Fed Chairman Jerome Powell regarding inflation, and took the gains off the table. Have a look at the 10-Q for New Residential Investments (NRZ) is this regard. The big question that faces owners of mortgage assets as well as bonds is do we hedge and which way do we lean? Chairman Powell’s comments about asset prices not being “inflated” certainly does not add to the FOMCs credibility when it comes to providing guidance or managing soft landings. The big losers in the proverbial policy mix seem to be weaker credits that need to raise capital, but sadly the market already has moved away. The science project/automaker known as Tesla (TSLA), for example, has suddenly reversed previous public statements and now is in the market with a $2 billion capital raise. Of course the true believers in the audience pushed the share price up after the announcement, but TSLA is still down 25% for the past year. The challenging situation facing Elon Musk’s love object TSLA is as nothing, however, compared to the task facing Deutsche Bank, which has been trying to raise new capital for years without success. With the failure of merger talks with Commerzbank AG (CBK), the lack of progress at Deutsche Bank presents a growing risk to the global financial system. In our conversation, Dübel reminds us of the obvious, namely that the largest “bank” in Germany is not really a bank at all when compared with US institutions. Even the $2 trillion asset JPMorgan Chase (JPM) is still more than half core deposit funded and boasts a significant loan book focused on small and medium size enterprises (SMEs). A fatal flaw in the business model of Deutsche and many other private German lenders has led to the present juncture. Deutsche seems so toxic due to bad loans and inadequate disclosure that it cannot raise new equity capital or combine with another institution. “In a nutshell, German (and Japanese) banks are traditionally bond buyers and not lenders, notes Duebel. “All of them, not just Deutsche and Commerzbank AG. Germany doesn’t have a pension system, so much of our surplus has to go through bank deposits and bonds bought by banks.” He notes some of the structural differences between banks in Germany and the US, but cautions that these disparities are not sufficient to explain the decline of German banks. “Structurally they didn’t build up international retail and SME lending as opposed to, for example, BNP Paribas (BNP). As their corporate client base increasingly became banks themselves, Deutsche thought they could compensate through trading income,” he notes. “Of course the strong cooperative and public banking system made the domestic retail/SME market difficult, but that is no excuse. Consider the international success of BNP or Société General (SG) against strong domestic co-operative bank competition. German banks used to be internationally strong in Latin America, Russia and the Middle East, these markets are history today.” Once the focus on traditional corporate and SME lending started to fade, Deutsche Bank and others were lured by the big returns of global investment banking, notes Dübel. “Being securities-overweight, they jumped into extremely crowded investment banking, where banking is dominated by the soccer model (most profits end up with staff, not shareholders),” he relates. Dübel notes that Deutsche and other German banks reaped a large share of their profits from taking market as opposed to credit risk, which is extremely curve- and volatility-sensitive. In addition, due to weak regulations, the German banks pushed up risk levels across their portfolio, with disastrous results. “Where they ventured into credit risk especially,” Dübel notes, “Deutsche focused on the synthetic market where it didn’t have a natural hedge due to the absence of a real credit portfolio. They ran into legal troubles when seeking those opportunities in local governments, retail investors, etc. They were brutally hit by adverse selection in bonds from Anglo investment banks during the crisis. And they contributed to inflating the economy of our neighbors and the U.S. via the bond markets. With ZIRP and only low-yield alternatives in the bond market, Deutsche effectively was bailed out by American and German governments without any consequences.” Dübel believes that the key issue as first mentioned is the unhealthy structural development, that is, management mistakes at Deutsche. “Achleitner (Allianz, Goldman) fired Cryan because he wanted to correct the investment banking bias. Now he trapped himself into something worse,” says Dübel. “I believe in contrast that the money laundering allegations against Deutsche Bank are mostly politically driven. Look who is talking. Details are very hard to verify.” Dübel adds: “Also let us not forget that international banking is as brutal as international oil. German banks were strong for example in Russia and Iran – these countries were lost as clients due to political pressure. One serious mistake they made is to leave everything in between Central/Eastern Europe to Italian and Austrian banks. So bizarrely, today Unicredit (CRIN) of Italy is a more serious contender for a Commerzbank takeover today than Deutsche.” As we’ve noted in The IRA previously, Deutsche has been struggling to make a bad business model work for over a decade. Faced with the fatal structural flaws in the business, the bank has drifted without clear direction from its board of directors and management. German pride makes it impossible for the government of Chancellor Angela Merkel to admit the obvious, namely that Deutsche Bank needs to be wound down and sold. And the public anger at big banks makes it politically impossible for the German government to take an example from Italy and lead this process. Thus we wait to see a solution to the financial and operations problems at Deutsche Bank as the moral hazard risk facing the markets grows. More Reading Can we privatize Fannie Mae and Freddie Mac? Really? https://www.nationalmortgagenews.com/opinion/can-we-privatize-fannie-mae-and-freddie-mac-really? When Deutsche Bank’s Crisis Becomes Our Crisis https://www.theamericanconservative.com/articles/when-deutsche-banks-crisis-becomes-our-crisis/ #DeutscheBank #Dübel

“Stock prices have reached what looks like a permanently high plateau.” Irving Fisher Autumn 1929 New York | Is the free ride over for financials? For the past decade, banks and other leveraged players have basked in the warm embrace of artificially low interest rates and not quite so low yields on various asset classes. The just completed cycle of Q1 2019 earnings for public companies suggest that the outlook for financials may be a good bit less accommodating than the recent past. One trend we note in the latest earnings cycle was the number of US banks that were explicitly guiding down investor expectations with respect to future net interest margin or NIM. The state of confusion with respect to interest rates and yields seems to have thrown a spanner into the proverbial gearbox of Wall Street hyperbole. Our survey of bank earnings suggests that the year-over-year change in funding costs in Q1 may exceed the 70% rate of change in Q4 2018. Just about everywhere you look, one chart seems to describe whatever asset class is under examination. A typical example is the chart below which shows the S&P 500 (SPX) over the past year. Notice the yawning crevasse where we all stood in late December of 2018, when securities issuance in the United States nearly stopped. Looking at U.S. Bancorp (USB) , for instance, which we own and is among the better performers among the largest banks, the market value of the common equity has not quite returned to the levels seen around Halloween. With most financials, we’ve basically waltzed sideways over the past 12 months, albeit with lots of volatility to amuse everyone. Looking at large cap financials as a group, we’re basically back to where we stood in October of last year. The December massacre engineered by Chairman Jay Powell and his colleagues on the Federal Open Market Committee left an impression on just about every asset class we surveil. Could it be that our colleagues among the ranks of bank analysts have finally figured out that the wind has shifted when it comes to NIM for banks and non-banks alike? Looking at the world of leveraged loans, for example, the volumes have not returned to this once toni neighborhood in the world of junk credit. Joe Rennison writes in The Financial Times that the “rout” in leveraged loans continues, driven in part by falling interest rates of all things. He notes that total outflows from the sector reached $26 billion since November, when the wheels began to seriously fall of the cart in the world of credit. “The long stretch of outflows has dented the assets of some of the biggest loan fund managers,” notes Rennison, but adds optimistically that “loan prices have recovered from a sell-off in the fourth quarter of 2018.” One of the great things about watching monetary economists try to “fine tune” monetary policy, an idiocy we today refer to as macroprudential policy, is that it creates great trading opportunities for those with strong constitutions and the ability rationalize the nonsensical. Thus we lightened up on mortgage exposures in December, believing the proverbial credit bottom in that asset class is nigh, but loaded up on USB common and preferred, and even some Citigroup (C) preferred as well. Of course the precursor to the December massacre was seen in August of 2018, when credit spreads began to move. By October, high yield spreads set a trough of sorts around 325 bp over the curve and started to move higher, peaking just shy of 550 bp over on January 3, 2019. As Feldkamp’s first rule states, when bond credit spreads widen, wealth is destroyed and economic growth suffers accordingly. The chart below shows high yield and investment grade spreads. Spreads have come back strongly since January, one reason why stock prices have recovered and even hit new highs. If you want to pick two indicators to watch as a general guide to market moves, credit spreads and the SPX are probably the two best broad indicators around. As we noted in Financial Stability (2014) : “Understanding what moves credit spreads allows us to construct and test policies that allow the United States to create and sustain financial stability.” What concerns us about the present day is the widely held assumption that the artificial increase in asset prices engineered by the FOMC since 2010 is permanent, a view we ourselves have advanced with respect to residential real estate. But maybe not. Could it be that bank credit costs are set to rise after years of artificially low levels of loss? Economists of a century ago were perhaps too involved in the euphoria of the markets, as in 1929 when Irving Fisher uttered his now infamous phrase about stock prices. Yet today’s economists are entirely divorced from the markets, surrounded by the conflicts cordon that encases all government officials in a sterile void. Financial breaks like 1907 or 1929 or 2008 are long in the making, however, and usually start from the periphery of the financial markets and then work towards the center. The Great Crashes of 1929 and 2008 both were preceded by a decade of boom and bust in sectors of the real economy far from lower Manhattan. Thus when we see growing deceleration in once red hot real estate markets around the country, we do start to wonder. Images of the great Florida real estate boom of the mid-1902s come to mind. As John Kenneth Galbraith wrote in “ A Short History of Financial Euphoria ,” the boom of the mid-1920s started in the Sunshine State: “And present also was leverage; lots could be purchased for a cash payment of around 10 percent. Each wave of purchases then justified itself and stimulated the next. As the speculation got fully under way in 1924 and 1925, prices could be expected to double in a matter of weeks. Who need worry about a debt that would so quickly be extinguished?” Kinda sounds like the leveraged loan market, does it not? As we’ve noted over the past many months, credit risk in bank 1-4 portfolios have been negative for several quarters now. Yet if the prices of more expensive residences are now under pressure, can higher bank credit costs be far behind? The chart below is from Weiss Analytics (Note: Whalen Global Advisors LLC is a shareholder in WA) shows the percentage of houses falling in value in various markets around the US. Suffice to say that high end home prices are decelerating in some of the most desirable areas. The WA home price index includes more than 80 million residential homes. Source: Weiss Analytics Keep in mind that in many of the hottest markets around the US, there were virtually no homes falling in price three years ago. The picture has changed rather significantly over the past 18 months. If the falling home price trend described in the chart above is confirmed, then we would expect to see increased pressure on net default rates across the mortgage sector. As we’ve noted before, low interest rates and tight spreads have the benefit of concealing credit risk for a time, but eventually the proverbial trend line reverts to the mean. Loss given default for bank owned 1-4 family mortgages is currently negative, but the 40-year average loss is over 60% of the loan balance. If home prices fall significantly, defaults will rise – and this will occur just as bank funding costs will have fully normalized. For these and several other reasons, the free ride in financials c/o the FOMC may truly be over. As Galbraith wrote: "Financial genius is before the fall." #NIM #Galbraith #Financials

New York | Last week the Mortgage Bankers Association released their annual production report for 2018. It is not a pretty picture. The Federal Open Market Committee has supposedly been “helping” the housing finance sector for years by purchasing long-dated securities, yet mortgage lenders have turned in their worst performance in decade. The MBA estimates total residential mortgage production volume at $1.64 trillion in 2018, down almost 7% from $1.76 trillion in 2017. “In basis points, the average production profit (net production income) was 14 basis points in 2018, compared to 31 basis points in 2017. In the first half of 2018, net production income averaged 18 basis points, then dropped to 9 basis points in the second half of 2018,” reports Marina Walsh of the MBA. “Since the inception of the Annual Performance Report in 2008, net production income by year has averaged 49 bps ($1,020 per loan).” The good news for the mortgage industry is that, since December when the FOMC did a double pirouette and stopped hiking interest rates, long-term bond yields have fallen and lending volumes have picked up. While increased lending results did not show up in the Q1 earnings for the largest banks, there was clearly a surge of activity in the first three months of 2019. Joel Kan, MBA's Associate Vice President of Economic and Industry Forecasting opined: "Purchase activity remained strong and increased slightly, reaching its highest level since April 2010. The spring buying season continues to be robust, with activity more than 7 percent higher than a year ago and up year-over-year for the ninth straight week." Could it be that after years of monetary chemotherapy the housing sector is recovering of its own accord, despite the “help” from the FOMC? The answer is yes. The smart leaders in the industry are positioning for stronger volumes down the road and lower interest rates. Unlike heavily regulated commercial banks, mortgage firms tend to be quite nimble and highly sensitive to changes in the sales cycle caused by interest rate movements, prepayment rates and other factors. Of note, after peaking around Thanksgiving 2018, interest rates seemed to bottom at the end of March and have risen in the first half of April. But the big obstacle to profitability for independent mortgage banks remains the cost to originate or acquire a loan. The MBA reports that total loan production expenses - commissions, compensation, occupancy, equipment, and other production expenses and corporate allocations - increased to $8,278 per loan in 2018, up from $8,082 in 2017. Excessive regulation at the state and federal level is a big component of higher loan production costs. Another recurring theme is a scarcity of mortgage related assets, which like houses are being produced in too little quantity for meet market demand. The result is a price war among the major residential loan aggregators, but you won’t read about it in the financial media. Suffice to say the falling volumes put increased upward pressure on secondary loan prices. Many banks and other owners of 1-4s simply keep the assets in portfolio instead of selling them. The chart below from SIFMA shows that many asset classes and especially mortgages and CLOs have not yet recovered from Q4 2018. Having spent the past two weeks on the road attending mortgage events on both coasts, we have a pretty good view of the state of the mortgage sector and where things are headed. As in 2018, liquidity remains the big concern in the industry, in large part due to paltry profits but also because of the absolute increase in funding costs. Credit concerns are there, but so far the numbers related to credit costs remain very muted and, indeed, extraordinary. Credit costs for bank owned 1-4s remain negative at the end of Q1 2019, for example, with serious delinquency rates at just 2% (200bp) and charge-offs of just 30bp. We heard Mark Fleming, Chief Economist at First American, talk about whether 2019 is the year that the housing market turns and ends it’s 7-year bull run. The good news is that the number of households is finally starting to grow, but supply remains the key constraint. And many households are moving from expensive coastal markets and into more affordable markets such as NC, TX, IN, CO and OH. This is bad news for states like NY, CT and NJ, where an exodus of affluent homeowners to other states is finally forcing sellers to capitulate in the high end suburban markets. San Khater, Chief Economist at Freddie Mac, likewise confirmed that a larger cohort of younger buyers is entering the market and that first time buyers are being forced to move further from the city center to find affordable housing. With the median age of the first time home buyer in the early 30s, Khater sees an increase in younger buyers looking for their first house. Of note today’s mortgage production is pristine in terms of delinquency compared with 2008-2014 mortgage loan vintages. While high-end home prices may be softening, home price appreciation remains robust at the lower end of the price scale, according to Laurie Goodman, Co-Director, Housing Finance Policy Center at Urban Institute. Significantly, Laurie believes that we currently have a 330k deficit in terms of the number of new homes being constructed vs new households created. Whereas the supply of new homes exceeded demand in the 2000s, today the opposite is the case due to soaring land prices and restrictions on new home construction. A scarcity of assets is not just visible in the market for homes and the secondary market for residential loans. Mortgage servicing rights or MSRs continue to trade at record multiples, this even after the bond market rally in Q1 2019 and the related downward marks on MSRs recorded in earnings for many large cap financials. Note that banks now own less than half of the $110 billion or so in total residential MSRs, as shown in the chart below. As and when default rates rise, the bull market in MSRs will end. Levered investors will flee the cost of default servicing. MSRs are naturally occurring negative duration assets, the polar opposite of a loan or a fixed income security, but with a short credit put position attached. Yet in a stable housing market with falling loan volumes and rising asset prices, MSRs are trading at premium prices. In the financial hunger winter engineered by the FOMC under Ben Bernanke and Janet Yellen, MSRs were the best performing fixed income asset class. Will this be the case in 2019 and beyond? Or will winter finally arrive for home prices in 2020? Our view is that home prices are unlikely to fall significantly. Scarcity of assets, soft volumes and low profits are and will be the watchwords in the residential housing sector for 2019.

Orlando | This week The Institutional Risk Analyst is participating in the Information Exchange sponsored by Black Knight, Inc. (BKI), the premier provider of integrated technology, data and analytics for mortgage lenders. We'll be joining Laurie Goodman of Urban Institute, Chris Flanagan of Bank of America, Sam Khater of Freddie Mac and Ed Pinto of American Enterprise Institute for a Super Session on the housing economy. With long-term interest rates falling, the mood in the mortgage industry is much improved and lending volumes are rising. Will profitability return in the yield spread famine created by the central bankers? Maybe. Sadly short-term interest rates remain elevated, held up by the errant policies of the Federal Open Market Committee. Significantly, even as the 10 year Treasury note sits at 2.5%, short-term interest rates are fundamentally linked to funding costs for banks and other leveraged investors. Source: US Treasury Last week Wells Fargo & Co (WFC) and JPMorgan Chase (JPM) reported earnings, in both cases exceeding Street expectations. But the results from both WFC and JPM confirm our expectations with respect to rising funding costs, which continue to grow by mid- to high-double digit rates or roughly 4x the rate of increase in bank asset returns. In the case of JPM, interest expense rose 70% year-over-year from $4.4 billion in Q1 2018 to almost $7.5 billion in Q1 2019. By Q1 2020, we expect to see quarterly interest expense for JPM over $12 billion. To give you some context, JPM’s net interest income was $14.5 billion in Q1 2019. While JPM is guiding investors to higher earnings, nobody expects the House of Morgan to grow asset returns by $5 billion in the next three quarters. For WFC, total interest expense rose 50% from $3.1 billion in Q1 2018 to $4.7 billion in Q1 2019. By Q1 2020, we expect to see WFC’s funding costs rise to something over $7 billion. To compare, WFC’s net interest income was $12.3 billion in Q1 2019. WFC has provided guidance to the Street for declining earnings and revenue through the end of 2019. Even were interest rates to remain unchanged over the next year, the cost of funds for the US banking industry is likely to continue increasing as bank deposit and debt costs normalize. Whereas in the period between 2008 and 2014 funding costs fell faster than bank asset returns, now the opposite is the case as we discussed on BNN last week. Bank funding costs are rising 3-4x asset returns as interest expense normalizes back to the $70-80 billion range. At Q4 2018, total funding costs for the banking industry were just shy of $40 billion. As noted in a previous comment, we expect quarterly bank funding costs to be over $60 billion by year-end 2019. To provide some perspective, the net income of the entire US banking industry was $59 billion in Q4 2018. Since 2014 when bank funding costs troughed at $11 billion per quarter, interest expense has grown four fold and at an accelerating rate. Source: FDIC Since much of the growth in bank interest income is due to balance sheet growth, the cost of funds for the industry is likely to stabilize well above $100 billion per quarter vs the pre-2008 levels of $80 billion. Total assets of the banking industry was $13.8 trillion at the end of 2008 vs $17.9 trillion at the end of 2018, a 30% increase. This is one reason why we believe that net interest income is likely to flatten and start to decline this year and beyond, as shown in the chart below. Source: FDIC, Whalen Global Advisors LLC James Grant writes in Barron’s this week: “Radical monetary policy, and the interest rates that go with it, advantage some, punish others. Speculators gain, savers lose. The rich do better than the poor. On balance, has the decadelong experiment in interest-rate suppression yielded the expected net benefit? The answer—'no’ — is best explained by the first economist who uttered the five wise words. ‘There ain’t no free lunch.’” Between 2008 and 2014, the FOMC subsidized the US banking sector to the tune of tens of billions per quarter in incremental income. Now as the financial markets slowly claw their way back to normal, banks and leveraged investors are entering a dangerous period of falling margins over funding and uncertainty about the future direction of interest rates. Without a complete capitulation by the FOMC and short-term rate cuts, we see no avenue for bank's to avoid a squeeze on net interest income in coming quarters. Yes, President Trump and Larry Kudlow are right about the Fed and interest rates. This novel and ultimately deflationary situation facing investors is entirely the fault of the FOMC and other central banks, which persist in thinking that negative interest rates are somehow helpful in terms of encouraging economic growth. But in fact savers, bond holders and now financial institutions are paying a very high price for the speculative fancy of global central bankers. As Warren Buffett told Yahoo Finance’s editor-in-chief, Andy Serwer : “I think, now, there’s still $11 trillion, at least, of government debt around the world that’s at a negative rate. So we’ve never seen it before.” No indeed. #BlackKnight #BKFS #JPM #WFC #WarrenBuffett #JimGrants